Stocks are back at record highs, and yet the S&P 500 is screening as cheap. What gives?
How can the S&P 500 hover in record territory and still look cheap?
Wall Street keeps insisting the S&P 500 looks like a bargain after July's selloff, with a couple of popular valuation metrics helping to make that case.
But with the large-cap index making a return to record territory on Tuesday after a two-month hiatus, investors might want to take those suggestions with a grain of salt.
The S&P 500 SPX last week traded at a forward price-to-earnings multipe of 19.42, its lowest level since March 30 and below its five-year average of 20.24, according to FactSet data. The forward P/E has compressed 10% from 22.2 earlier this year.
Another popular metric, the forward price-to-earnings-to-growth ratio, better known as the PEG ratio, hit a multiyear low in late July. That metric compares a stock's price with the expected rate of growth that analysts have penciled in for the company's earnings over the coming years.
The S&P 500 traded at a PEG multiple of 1.02 on July 23, the lowest level since June 2012, according to FactSet data. A multiple of 1 means the stock is traded at fair value relative to its expected earnings growth, while a sub-1 multiple suggests undervaluation. The further the ratio moves above 1, the more expensive a stock looks - at least on paper.
When considering valuation metrics like forward price-to-earnings ratio, investors should keep in mind that valuations are rarely useful for timing short-term market moves.
Also, one reason the two above-mentioned metrics look so good is that analysts have been penciling in an unusually swift pace of earnings growth in the years ahead, based on the expectation that trillions of dollars in artificial-intelligence investment will come good.
Indeed, Josh Jamner, senior investment strategy analyst at ClearBridge Investments, said the recent compression in stock valuation has been driven primarily by improving corporate earnings expectations, rather than investors simply paying higher prices for stocks.
"When we've had stock selloffs, the earnings expectations have still tended to hold up, so it's been more of a multiple-contraction story to the downside," Jamner told MarketWatch on Tuesday.
"We're in the early part of earnings season, but as we're working our way through it, results for this quarter look pretty good and the expectations for the back half of the year are pretty healthy," he added. "So the earnings story is intact, and that gives us encouragement that the rally that we've seen is supported by fundamentals."
Both the P/E and PEG ratios are traditional stock valuation metrics, but they differ in how they assess a stock's value. A higher P/E suggests that investors expect strong future earnings growth, although it can also mean that a stock is expensive relative to its current earnings.
PEG, on the other hand, takes expected earnings growth into account alongside the P/E ratio. For example, a stock with a P/E of 20 may appear expensive on its own - but if its earnings are expected to grow at 20% annually, its PEG ratio would be 1. That's a level often viewed as fairly valued, although PEG ratios rely heavily on forecasted growth, which is based on Wall Street estimates and can be misleading at times.
The blended earnings-growth rate for the S&P 500 for the second quarter of 2026 last week increased to 47.4% from 38.0%, according to FactSet data. If 47.4% is the actual growth rate for the quarter, it would mark the highest year-over-year earnings-growth rate reported by the benchmark index since the second quarter of 2021.
But in the view of BofA Global Research, while the S&P 500 does look somewhat cheaper based on forward P/E ratio, the index still screens as historically expensive when valued based on sales or free cash flow. Its year-over-year sales growth has lagged behind capital-expeditures growth by a much wider margin than usual, noted a team of BofA strategists led by Savita Subramanian, head of U.S. equity strategy.
That mismatch may be a warning sign, since massive AI capex could put downward pressure on valuations if investors think that the spending is consuming too much cash without generating enough returns.
"If the AI spending heralds an industrial revolution, historical multiple analysis is less relevant. But if it proves a more conventional capex cycle, history argues for a 15% to 30% derating as the market reprices capital intensity over innovation," Subramanian and her team said in a Monday client note.
But Jamner of ClearBridge said the fact that revenue growth is lagging behind capex is not a surprise.
"We're in a relatively early innings of the broader AI story," he said. "Investors are obviously focused on signs of where revenues are starting to show up and when they might show up and continue to grow in the future, but the fact that capex growth in this infrastructure-buildout phase is taking the lead is understandable."
Moreover, the broadening of earnings delivery in the second quarter is a further indication that this earnings-growth cycle is healthy, Jamner added.
To be sure, there are other popular valuation metrics that paint a much different picture. The so-called Buffett Indicator, which measures the total value of the U.S. stock market against annual gross domestic product, recently reached its highest level on record. Also, the S&P 500 Shiller CAPE ratio was recently hovering near its highest level since the dot-com era.
As of Monday, eight of the 11 S&P 500 sectors had reported double-digit earnings growth for the second quarter of 2026 - led by the energy XX:SP500.10, communication-services XX:SP500.50, consumer-discretionary XX:SP500.25 and information-technology XX:SP500.45 sectors, according to FactSet data.
U.S. stocks were sharply higher on Tuesday afternoon as oil prices (CL00) (BRN00) were falling on hopes that a U.S.-Iran deal to reopen the Strait of Hormuz could be near. The Dow Jones Industrial Average DJIA was up 1.9%, while the S&P 500 was rising 1.8% and the Nasdaq Composite COMP was popping 2.4%, according to FactSet data.
-Isabel Wang
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